Terminating Traditional Pensions

By Frank Armstrong III

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JANUARY 2007 - Are traditional pension plans an endangered species? Defined benefit (DB) pension plans create high costs and risks that have contributed to some spectacular bankruptcies, such as United Airlines, which terminated its pension in 2005. General Motors was also in the news when its pension fund reached shocking debt levels last year.

According to the Pension Benefits Council, in 1980, 38% of Americans had a DB pension as their primary retirement plan. By 1997 it was down to 21%, and this number has likely fallen further in the last several years. In addition, an increasing number of underfunded plans have been taken over by the Pension Board Guarantee Corporation (PBGC), a federal government–chartered agency that insures pensions.

Unlike a defined contribution plan, a defined benefit has some or all of its benefits guaranteed. If a DB plan is underfunded—meaning that there is not enough money available to satisfy all the covered benefits—then the PBGC must step in. Accordingly, the termination of a defined benefit plan is much more complex than the termination of a defined contribution plan.

The Options

If an employer freezes an existing DB plan, the plan continues, but employees accrue no further benefits. The company may need to make further contributions if the plan is underfunded when frozen.

If the company terminates the plan, either the accrued benefits, including all unvested benefits, must be paid out as a lump-sum equivalent, or the plan must purchase a annuity from an insurance company. It goes without saying that the plan must be fully funded when terminated.

Usually a company freezing or terminating a DB plan will then start some form of defined contribution plan to take its place. It is unlikely that the benefits of the two plans will be equivalent. DB plans tend to favor older, long-term employees. These employees may be worse off, while younger employees may find that they potentially have higher projected benefits.

Sometimes a plan will be converted into another form of DB plan with entirely different sets of benefits. In a famous recent case, older IBM employees successfully argued that the conversion to a cash-balance pension was blatantly discriminatory because the new formula actually reduced benefits with each additional year of service.

Distress or Involuntary Terminations

Occasionally, companies fail outright, taking their DB plans down with them. The Employee Retirement Income Security Act (ERISA) established the PBGC to provide employees with at least partial insurance of their accrued benefits in DB plans. Today, almost a million present and future retirees look to the PBGC for their retirement benefits.

Single employer plans pay an annual per-participant fee of $19 as well as 0.9% of any amount the plan is found to be underfunded. The premium is mandated by federal law, and to date has not been sufficient to cover existing liabilities. Even though the PBGC itself is insolvent, Congress has been reluctant to raise the premiums, perhaps fearing that it might accelerate the trend away from DB plans. The recently passed Pension Protection Act of 2006 includes provisions designed to strengthen DB plans, but its longer-term effects remain to be seen.

When a plan does not have sufficient assets to pay all its intended benefits and the employer is in such distress that continuing the plan might cause the company to fail, it can petition the PBGC for a distress termination. In a distress termination, the PBGC steps in to pay “guaranteed” benefits and attempts to recover the balance from the employer, either over time or in bankruptcy.

Should the PBGC find that it is in the best interest of the employees, the plan, or the PBGC itself, they can take over a plan without the employer’s consent. Finally, if a firm suspends operation or cannot continue as a going concern, the PBGC will take over the plan.

The Road to Insolvency

The stock market decline of 2000–2002 devastated many DB pension plans. Much of this grief was self-induced and avoidable.

Among the many factors that go into determining annual pension expense, none is more critical than the plan’s rate-of-return assumption. If the plan assumes a high rate of return, then the annual cost estimate is reduced. This is very tempting. If a company can lower pension costs, the savings go right to the bottom line. But hoping for higher returns doesn’t make it so. If those returns fail to materialize, the plan will soon be underfunded, and the annual costs will rise again to reflect the additional deposits required to fully fund the plan.

The only way to ensure that a DB plan will not be underfunded is to buy long-term bonds that mature as needed to fund plan commitments; in other words, match assets with future liabilities. But this implies a very low rate of return and high annual costs. So most DB plans invest in a mixture of stocks and bonds to increase the rate of return. The more volatile the assets, the higher the assumed return, and the higher the risk.

During the late 1980s and the 1990s, many plan fiduciaries increased their rate-of-return assumptions to reduce estimated annual costs. Lulled by long market advances, actuaries, the Labor Department, employees, and labor unions all bought into the decision. Plans took higher levels of risk to attempt to meet their rate-of-return assumptions and did not properly diversify their portfolios. When the market tanked, some companies found that their DB plans were suddenly underwater at just the time that their business was in distress.

Airline Pensions Hard Hit

Legislation enacted in July 2004 relaxed funding standards across the board and specifically allowed two distressed industries, airlines and steel, temporary additional underfunding. If this legislation represented a massive bet for the government, then the Pension Protection Act of 2006 could be seen as doubling down on this bet. The new law generally requires plans to reach full funding over a seven-year transition period, with longer periods specifically allowed for airlines. If the funding levels do not recover over time, the PBGC will be forced to take on plans that have become even more severely underfunded. With the PBGC itself already severely in the red, the prospect of allowing any employers to further underfund their plans may come back to bite the agency with a vengeance.

Recent legislation was driven by the fact that the airline and steel industries, already financially weak, were particularly hard hit in the wake of the terrorist attacks of September 11, 2001. United Airlines terminated all its DB plans, dumping an additional 120,000 employees into the system with a projected cost to PBGC of over $5 billion. This follows the distress termination of the US Air’s pilots’ pension plan. As one airline after another dumps pension plans on the PBGC, the temptation for the remainder increases. The industry is highly competitive, lacks pricing power, and suffers from overcapacity; established airlines are being undercut by start-up ventures with lower operating costs. Cutting costs by dumping pensions may be the only way some carriers can survive. Unfortunately, the U.S. taxpayer may end up paying the bill.

Effect on Plan Participants

Rank-and-file employees may be fully covered, but highly compensated employees will find that the PBGC guarantee covers only a small portion of their benefits. They can be financially devastated by a plan termination. While plans can fund to a maximum of $165,000 per year at normal retirement, the PBGC maximum guaranteed benefit for plans that terminated in 2004 was $44,368.

When plans sponsored by distressed companies offer a lump-sum benefit, the threat of possible plan termination can cause a “run on the bank,” where senior employees attempt to secure their lump sum prior to the termination. For example, Delta Airlines had 300 pilots retire in June 2004 alone, 266 of them early. Unfortunately, every employee who succeeds in securing a lump-sum payment further weakens the fund for remaining participants. This downward spiral increases the probability that the plan will find itself in a distress termination.

Interestingly, if companies maintain multiple DB plans for different employee groups, they may have the option to pick and choose which plans to terminate. For example, US Air, operating under Chapter 11 bankruptcy, was allowed a distress termination of its pilots’ pension plan while continuing other employees’ pensions. Senior pilots found their benefits cut by over $100,000 per year. That represents a roughly $2 million decrease in assets that had accrued over a 30-year career for each pilot.

The PBGC’s process is often arbitrary and capricious. When challenged, it has proved to be a tireless litigator. For example, when the PBGC took over the pilots’ pension plan at Eastern Airlines, it was almost fully funded, while other groups were greatly underfunded. The pilots had, through the collective bargaining process, negotiated for increased funding for their plan, which was paid for by reducing their pay. Nevertheless, the PBGC promptly transferred the pilots’ funds to less fully funded Eastern employees’ plans. This shortchanged the pilots’ plan, but reduced the PBGC’s liability for the other plans. This “theft” was never challenged in court. When Pan American Airlines folded, its pilots’ pension plan was underfunded. During the administrative process the stock market rebounded, greatly enhancing funding levels. The PBGC kept the additional funds and successfully argued in court that it was not the fiduciary of the plan, but its insurer. The pilots received minimum benefits rather than the benefits the plan could have provided with the enhanced asset values.

An Uncertain Future

The trend away from the traditional DB plan is probably irreversible, as companies increasingly attempt to reduce costs and avoid possible future liabilities for underfunding. Employees currently covered under DB plans must consider that their anticipated benefits may be reduced in the future. This is particularly of concern in distressed industries where highly compensated employees could experience significant benefit cuts. As in almost all other aspects of DB pension plans, employees are along for the ride, with little or no control over their plans.

Frank Armstrong III, CFP(r), AIF(r), is the founder and principal of Investor Solutions, Inc., a fee-only registered investment advisor.





















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